CREDIT DEFAULT SWAP (CDS)

It is a combination of following 3 words: Credit : Loan given 

Default : Non payment 

Swap : Exchange of Liability or Risk 

Accordingly, CDS can be defined as an insurance (not in stricter sense) against the risk of default on a debt which may be debentures, bonds etc. 

Under this arrangement, one party (called buyer) needing protection against the default pays a periodic premium to another party (called seller), who in turn assumes the default risk. Hence, in case default takes place then there will be settlement and in case no default takes place no cash flow will accrue to the buyer alike option contract and agreement is terminated. Although it resembles the options but since element of choice is not there it more resembles the swap arrangements. 

Amount of premium mainly depends on the price of underlying and especially when the credit risk is more. 

Main Features of CDS 

The main features of CDS are as follows: 

1. CDS is a non-standardized private contract between the buyer and seller. Therefore, it is covered in the category of Forward Contracts. 

2. They are normally not traded on any exchange and hence remains free from the regulations of Governing Body. 

3. The International Swap and Derivative Association (ISAD) publishes the guidelines and general rules used normally to carry out CDS contracts. 

4. CDS can be purchased from third party to protect itself from default of borrowers. 

5. Similarly, an individual investor who is buying bonds from a company can purchase CDS to protect his investment from insolvency of that company. Thus, this increases the level of confidence of investor in Bonds purchased. 

6. The cost or premium of CDS has a positive relationship with risk attached with loans. Therefore, higher the risk attached to Bonds or loans, higher will be premium or cost of CDS.

1. If an investor buys a CDS without being exposed to credit risk of the underlying bond issuer, it is called “naked CDS”. 

Uses of Credit Default Swap 

Following are the main purposes for which CDS can be used. 

(a) Hedging- Main purpose of using CDS is to neutralize or reduce a risk to which CDS is exposed to. Thus, by buying CDS, risk can be passed on to CDS seller or writer. 

(b) Arbitrage- It involves buying a CDS and entering into an asset swap. For example, a fixed coupon payment of a bond is swapped against a floating interest stream. 

(c) Speculation- CDS can also be used to make profit by exploiting price changes. For example, a CDS writer assumed risk of default, will gain from contract if credit risk does not materialize during the tenure of contract or if compensation received exceeds potential payout. 

Parties to CDS 

In a CDS at least three parties are involved which are as follows: 

i. The initial borrowers- It is also called a ‘reference entity’, which are owing a loan or bond obligation. 

ii. Buyer- It is also called ‘investor’ is the buyer of protection. The buyer will make regular payment to the seller for the protection from default or credit event of reference entity. 

iii. Seller- It is also called ‘writer’ of the CDS and makes payment to buyer in the event of credit event of reference entity. It receives a regular pay off from the buyer of CDS. 

Example- 

Suppose BB Corp. buys CDS from SS Bank for the Bonds amounting $ 10 million of Danger Corp. In such case, the BB Corp. will become the buyer, SS Bank becomes seller and Danger Corp. becomes the reference entity. BB Corp. will make regular payment to SS Bank of the premium and if Danger Corp. defaults on its debts, the BB Corp. will receive one time payment and CDS contract is terminated. 

Settlement of CDS 

Broadly, following are main ways of settlement of CDS. 

(i) Physical Settlement – This is the traditional method of settlement. It involves the delivery of Bonds or debts of the reference entity by the buyer to the seller and seller pays the buyer the par value.

For example, as mentioned above suppose Danger Corp. defaults then SS Bank will pay 

$ 10 Million to BB Corp. and BB Corp will deliver $10 Million face value of Bonds to SS Bank. 

(i) Cash Settlement- Under this arrangement seller pays the buyer the difference between par value and the market price of a debt (whatever may be the market value) of the reference entity. Continuing the above example suppose, the market value of Bonds is 30%, as market is of belief that bond holder will receive 30% of the money owed in case company goes into liquidation. Thus, the SS Bank shall pay BB Corp. $ 10 Million - $3 million (100% - 30%) = $ 7 Million. 

To make Cash settlement even more transparent, the credit event auction was developed. Credit event auction set a price for all market participants that choose to cash settlement. 

CDS in India 

In India, RBI has come out guidelines on CDS in corporate bonds in 2011 which was revised in 2013. 

As per the guidelines CDS players have been divided into following two categories: 

(a) Market Makers: - These are comprised of commercial banks, primary dealers (PDS) and non-banking financial companies (NBFCs). They can buy or sell without any underlying position in the bond i.e. Naked CDS. 

(b) Users: - These are comprised of mutual funds (MFs), Insurance Companies, Housing Finance Companies, Provident Funds, Listed Companies and Foreign Institutional Investors (FIIs). They can use CDS only as a hedge tool to offset the risk of an underlying position, and are not allowed to sell CDS other than to exit the existing long positions. 

Note: For detailed guidelines, students can visit RBI’s website.